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No One Should Be Buying Single-Stock ETFs

(Bloomberg Opinion) –Issuers of exchange-traded funds plan to roll out a wave of single-stock ETFs. These funds, a handful of which are already available, will bet against individual stocks or amplify their daily moves or both. Needless to say, single-stock ETFs have not been greeted with enthusiasm. Regulators are sounding alarms about their risks. Financial advisers are warning investors to stay away. CNN called them apocalyptic.

My colleague and ETF guru Eric Balchunas thinks the reaction is “overly-hyperbolic pearl clutching,” and he’s not wrong, mostly because ETFs jumped the shark long ago. The ETF industry was once a proud refuge for investors from the wolves on Wall Street. The first ETFs in the 1990s and early 2000s were mostly low-cost index funds that tracked broad markets. In those days, investors could buy pretty much any ETF and expect to be financially better off over time.

Since around the mid-2000s, though, the ETF landscape has become increasingly treacherous. It started with funds that — like the new single-stock ETFs — bet against broad indexes or use borrowed money as leverage to juice their daily returns. Then came volatility funds, structured funds and ever more concentrated baskets of the most speculative stocks. These newer funds flipped the odds — the longer people dabble in them, the worse off they’re likely to be, at least relative to buying the broad market.

ETF issuers know this, so they pretend that their funds are intended for a niche audience. Greg Bassuk, chief executive officer of AXS Investments, the first company to introduce single-stock ETFs in the US, says the funds are geared toward “sophisticated, active traders.” But there aren’t many of those — the more sophisticated the investor, the greater the realization that active trading is ruinous. And I’ve never encountered an ETF issuer that doesn’t want as many investors as possible in its funds.  

The best that can be said about single-stock ETFs is that they allow people to pick stocks with borrowed money without the hassle of a margin account and that they limit losses to the amount invested, which isn’t normally true when betting against stocks. But those features only pave the way to more heartache. Picking individual stocks is notoriously difficult. Shorting them is even harder. Adding leverage just magnifies the losses.

The truth is that no one should be buying single-stock ETFs. So why are issuers doing this? The answer, of course, is to make money. “Niche” and complex ETFs charge a lot more than simple market-tracking funds. It’s classic Wall Street: Better to exploit investors than educate them.  

While single-stock ETFs are just getting started, they could dominate the industry. There are about 3,000 US-based ETFs and about 4,000 publicly traded US stocks, each of which can theoretically be packaged into multiple single-stock funds with varying amounts of leverage. Just as trading apps have made picking stocks easier and more popular, single-stock ETFs could conceivably extend that popularity to shorting or making levered stock bets.

And that could be problematic for everyone. The reason is somewhat wonky, as it always is with complex financial products, but the potential impact is familiar enough. “Any daily reset product, whether levered up or down, is mathematically procyclical, buying on up days, and selling on down days,” Dave Nadig, ETF expert and financial futurist at VettaFi, told me. “That has the effect of ramping price activity into the close, which means closing prices are heavily influenced by structural trading and bear little relation to natural supply and demand dynamics.” Translation: “The structure is in place for wild end-of-day swings that distort stock prices and make price discovery impossible.”

Despite the risks to investors, regulators are right not to stand in the way of single-stock ETFs and other complex funds. Their job is to make sure investors have the information they need to make good decisions, not guard them from every financial threat. Regulators may eventually have to intervene if single-stock ETFs pose systemic risks, but they’re too small to worry about now

There’s still a lot to like about ETFs. The best of them offer the lowest-cost, most tax-efficient way to invest in broad markets. The ETF industry has also nurtured styles of investing backed by decades of academic research, such as value, quality and momentum, giving investors more avenues to diversify their portfolios. But now that anything goes in ETF land, investors must be as discerning there as anywhere else when making financial decisions.   

So, no, single-stock ETFs are not the end of civilization. But they are a good reminder that purveyors of financial products are primarily in the business of making money for themselves, not their customers, even though they may occasionally pretend otherwise. While that may go without saying, there was a time when the ETF industry aspired to a higher calling. Those days are long gone.

More From Writers at Bloomberg Opinion:

  • The Fatal Flaw in Your Target Date Fund: Allison Schrager
  • Every Serious Couple Should Talk About Spousal IRAs: Erin Lowry
  • Single-Stock Levered ETFs Are Financial Mutants: Jared Dillian

To contact the author of this story:

Nir Kaissar at [email protected]

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